Year-end tax planning for individuals is more about skill than luck. Need proof? Here are seven ways clients can slash their personal tax bills in 2007.
1. Dodge the 'big, bad' AMT
Originally, the alternative minimum tax (AMT) was intended to hit only the wealthiest taxpayers. But now it's hurting millions of other individual filers.
At tax-return time, individual filers must go through the AMT calculation - the complex mishmash involving "tax preference" items, technical adjustments and an exemption amount based on filing status - to arrive at AMT liability (see table below). Then the filer must compare the result to his or her regular income tax liability. If the AMT figure is higher, the filer is stuck with the higher tax. The AMT rate is 26 percent on AMT income up to $175,000; 28 percent above that.
2. Strategy: Figure the potential AMT liability for clients right now. If possible, a client might reduce or eliminate the tax for 2007 by postponing tax preferences or avoiding them altogether.
On the other hand, if it's absolutely certain that an individual client will have to pay the AMT and he or she is in a regular tax bracket above 28 percent, the client might push more taxable income into this year. Reason: The extra income will be taxed at the AMT rate of no more than 28 percent under the AMT rules.
2. Observe new charitable-deduction rules
Usually, taxpayers can deduct the full amount of cash gifts made to charities. But tough new substantiation requirements apply to cash donations - including gifts by check or credit card - this year. Essentially, a donor must obtain a bank statement, receipt or written communication from the charity. The written communication should show the charity's name, the date of the contribution, and the donation amount.
Strategy: Make sure clients keep proper records of all monetary contributions. Otherwise, if a client throws spare change into a collection plate or gives other cash handouts, the individual may not be able to substantiate deductions for these amounts.
Encourage clients to write checks to charities or charge donations by credit cards when it's possible. The deduction can be claimed in 2007 if it's posted in 2007, even if the charge isn't paid off until 2008.
Tip: If a donor gives gifts of clothing and household goods in 2007, the donor may take deductions only for these items deemed to be in "good condition."
3. Keep dependency exemptions for college grads
Generally, a taxpayer can claim a dependency exemption for a relative if:
1) the taxpayer provides more than half of the relative's support and
2) his or her gross income doesn't exceed the personal exemption amount. The personal exemption amount for 2007 is $3,400.
However, the "gross income test" does not apply to a child who is either under age 19 or a full-time student under age 24. If a client's child graduated from school this year, this might be the last year the client can claim the exemption for the child.
Strategy: Make sure the client clears the half-support mark in 2007. For example, the client might pay the child's rent in December or pay other year-end expenses.
If the child has a job and banks the earnings, these amounts aren't counted as support the child provides for himself or herself.
Tip: The tax benefit of personal exemptions is reduced for certain high-income taxpayers. For 2007, the phaseout begins at $234,600 for joint filers; $156,400 for single filers.
4. Bunch medical expenses in one year
It's often difficult to qualify for medical-expense deductions. Reason: An individual can deduct only the excess of unreimbursed expenses over 7.5 percent of AGI. Otherwise, he or she receives no deduction.
Strategy: If a client is already over the 7.5 percent mark for 2007 - or close to it - the client should schedule routine medical and dental exams before year-end. This way, the client can write off the extra expenses on the 2007 return if they are paid in 2007 or charged to a credit card before year-end.
Conversely, if someone will not qualify for a medical deduction this year, that person might as well postpone nonemergency expenses to next year. Reason: The person will have a better shot at a medical deduction in 2008.
Tip: Don't forget to count medical expenses paid on behalf of a relative, if the client provides more than half of his or her support.
5. Convert nondeductible debt into deductions
A client generally gains no tax benefits for interest paid on debts incurred for personal reasons (e.g., a loan for a new family car). But an individual can deduct the interest paid on up to $1 million of "acquisition debt" used to buy, build or improve his or her principal or second residence.
In addition, an individual can deduct the interest paid on up to $100,000 of qualified home-equity debt. This includes a home-equity line of credit.
Strategy: Encourage a client to consolidate outstanding personal loans into home-equity debt (where it's permitted by state law). Then the client can deduct the interest on the home-equity debt, no matter how he or she uses the money. Of course, home-equity debt must be secured by the client's home, so this yearend technique should be used judiciously.
Tip: The same rules may be applied to one other home besides a principal residence, such as a vacation home.
6. Prepay state and local income taxes
Usually, taxpayers are in no rush to pay taxes. But certain exceptions apply.
Strategy: Have clients pay estimated state and local income tax bills early. By paying taxes in December that aren't due until early next year, a client can increase deductions for 2007.
However, the client should not use this technique if he or she expects to pay the AMT this year. Reason: State and local taxes are not deductible for AMT purposes.
Tip: A similar strategy may be used for mortgage-interest prepayment. But if a client doesn't do this in following years, in the year the client stops he or she will have deductions for only 11 months' interest.
7. Sidestep an underpayment penalty
If a client doesn't pay sufficient federal income tax during the year, he or she could be slapped with a tax penalty for underpayments. This includes amounts paid through quarterly installments and payroll withholding.
Fortunately, it's relatively easy to avoid the penalty through one of two common "safe harbor" rules. No penalty will be assessed if the client's payments for 2007 equal at least 90 percent of his or her 2007 tax liability or 100 percent of the client's 2006 tax liability (110 percent if AGI exceeded $150,000 in 2006).
Strategy: Instruct clients to adjust income tax withholding to satisfy either safe-harbor rule. Example: An individual can increase the amount deducted from year-end paychecks so that the total for 2007 exceeds the 100 percent (or 110 percent) safe harbor.
If the adjustment is made after clearing the Social Security wage base ($97,500 for 2007), the client will see little or no reduction in take-home pay.
Tip: If the client chooses, he or she can restore the previous withholding amounts for next year by filing a new W-4 for 2008.
Ups and downs of AMT exemptions
The government continues to put Band-Aids on the AMT problem. For instance, over the past few years it has bumped up the exemption amounts available to individual filers. However, as things stand now, the exemption amounts will actually decrease for 2007 to the levels that applied for 2000.
Tip: To make matters worse, the exemption amounts phase out for high-income taxpayers. The exemption is reduced by 25 cents for each dollar of AMT income above $150,000 for joint filers; $112,500 for single filers. These figures have not been adjusted for inflation.
Reprinted with permission from The Tax Strategist, November 2007. For continuing advice on this and numerous other tax strategies, go to www.TheTaxStrategist.net.
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